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July 30, 2004 GLOBAL MARKETS TREASURE HUNT Global Business Opportunities in Financial Market Risk Management Let UBOC Global Markets Group lend you a hand in managing the perils of global financial markets Global Markets Group Published by UBOC Global Markets Group. This report has been prepared from sources we believe to be reliable. We make no claim as to its accuracy. Any opinions expressed are not that of UBOC and/or its affiliates. UBOC may act as principal or as agent in a security mentioned. All prices and rates are subject to change without notice. Short-term Rates (1/1/00~): start of tightening cycle 10.00 9.00 8.00 7.00 6.00 5.00 4.00 3.00 2.00 1.00 0.00 Jan00 Union Bank of California 3M LIBOR Fed Funds Target Discount Rate Fed expected to raise Fed Funds target by 25bp on 8/10. Greenspan’s optimism for real or not? (p. 4) Investors may want to have short maturities: consider Auction Rate Notes. (p. 3) Prime Rate US$ back stronger again as Greenspan gives upbeat Testimony. (p. 2) Jul- Jan00 01 Jul01 Jan- Jul02 02 Jan- Jul03 03 $/¥ (1/1/03 ~): stronger US$ Jan- Jul04 04 Stuck with a high coupon swap but want to refinance? Consider an Extendable Swap. (p. 2) FX market waiting for Fed decision and pace of future rate hikes to determine course of US$. (p. 5) UBOC Global Markets Group - Serving Your Needs Let us help your customers with their global financial management needs. Foreign Exchange - Bernard Tsui (213-236-6943) Interest Rate Derivatives – Jeff Hiraishi (213-236-6731) Securities Trading & Sales – Jeff Katz (213-236-5097) Editor - Tomoko Iwakawa (213-236-6488) Distribution requests for Treasure Hunt may be directed to Karen Walton on (213-236-4253) 1 GLOBAL FX: Waiting for the Fed DERIVATIVES: Refinancing loan with an Extendable Swap The US$ was shaken out of its summer malaise on recent upbeat comments by Fed Chairman Greenspan who affirmed that the US economic recovery is firmly on track. In his Congressional testimony, Greenspan predicted that growth would accelerate in the IIH ‘04 and into ’05, maintaining that the timetable for rate hikes was intact, affirming the Fed’s most recent statement that rate hikes would be a “measured” pace. Earlier this month, however, the jobs report came in at +112,000 for June, well below the several previous months reports above +200,000. June Retail Sales also had the sharpest drop in 16 months, while June Industrial Production fell 0.3%, marking the first drop in 4 months. The rash of weaker economic reports led many to reevaluate the health of the US economy, resulting in the €/$ to rise to a 4 month high above $1.24/€. In light of weaker economic reports, market participants were caught off guard by Greenspan’s upbeat comment. The US$ quickly reversed course after his statements on prospects that the Fed’s timetable for rate hikes was intact. Adding to the US$ gains, Greenspan’s outlook for an economy gathering momentum was buttressed by July Consumer Confidence which came in a stronger +106.1 from +102.8 the previous month. In response, the €/$ fell to $1.2031 and the ¥ weakened to above ¥111/$. Meanwhile the euro-zone remains mired in sluggish growth. The European Union revised down its Q3 growth forecast to the 0.3-0.7% range. Growth remains anemic; Q1 GDP grew 0.6%, up from 0.4% in previous quarter. The European Central Bank has resisted calls to cut interest rates to spur growth citing inflation concerns. Inflation rose 2.4% in June, largely on the back of rising energy costs. With inflation becoming a growing concern, markets are instead speculating that the ECB’s next move could be towards raising rates as early as September. The ECB’s official stance towards interest rates is presently neutral. In contrast, the UK has been grappling with reining in strong domestic conditions. The Bank of England has raised rates 4 times since last November bringing the Base Rate to 4.5%, which made £/$ rise to 5-month highs at $1.8769/£. With unemployment at the lowest levels since 1975 and June inflation at 1.6%, market is anticipating another BOE rate hike soon. Similarly, Japan appears solidly on track towards recovery. The much-anticipated Tankan survey of business sentiment soared to 13-year highs. The government has raised GDP estimates to 3.5% for ’04, the strongest growth in 3 years. The Bank of Japan has pledged to maintain its zero interest rate policy that has underpinned the recovery. With further rate hikes in the US looming, the FX market is taking cues from the Fed and attention is once again focused on the US economy. The US$ appears set for further gains in the event the Fed continue to raise interest rates. Market participants will be closely scrutinizing US economic statistics to determine how soon and when the Fed will act. One of the challenges before borrowers in the current market is what to do with their existing swap(s) when deciding to refinance their loan. Based on an imminent view that the Fed will continue to follow through on their tightening cycle, combined with the need to borrow more money for a longer period, customers are looking at different strategies in restructuring their loan/swap. Since the existing loan is on a floating rate basis, the customer can terminate the loan at the end of the period cycle and refinance it without a prepayment cost. However, if there’s an existing swap, the customer can; 1) terminate the swap, cash settle it (in the money, or out of the money), and execute a brand new swap; 2) leave the existing swap in place, and execute a new forward starting swap; 3) execute an Extendable Swap. Extendable swap – Definition: terminate an existing swap and embed the gain or loss into a new longer tenure swap. If the swap is “in the money,” customer can terminate the swap and embed the monetary gains into the new swap to “buy down” the fixed rate. If the swap is “out of the money,” customer can terminate the swap and embed the loss into a slightly higher fixed rate, without having to pay a swap prepayment. Economically, there’s no advantages with the Extendable swap because your gain or loss will still be realized, however, it’s more of a convenience factor for the client because there’s no need to cash settle anything (payment to client if in the money, payment to UBOC if out of the money), or having to monitor two separate swaps at the same time. In reality, the prepayment gets paid over time. Example: Existing $5MM (bullet) swap maturing on 8/1/05 at 3.00% 1) The customer can decide to prepay the original swap for $25K, and execute a new $5MM swap from 8/1/04 – 8/1/09 at 4.40%. (2 transactions) 2) The customer can leave the existing $5MM swap (8/1/05 maturity) at 3.00%, and execute a new $5MM forward starting swap from 8/1/05 – 8/1/09, at 4.90%. This would give the client an average rate of 4.52% for the next 5 years. (Need to monitor 2 swaps) 3) The customer can execute a New Extendable swap where the customer terminates the original swap, embeds the $25K prepayment, and extend it out to 8/1/09 at a rate of 4.52%. The $25K prepayment, equates to a 12bp premium. (1 transaction) David Rhee Jeff Hiraishi 2 weak labor report most likely will force yields back down to test the recent lows. Once again, participants will probably pause before buying more bonds initially at the test of the low recent yields. A strong report and one can expect new highs in bond yields in anticipation of more rate hikes to come. From the FOMC meeting, investors should pay attention to whether the Fed acts, by how much they raise rates and their comments. Paying attention to this should give investors a read as to the near term direction of the market. SECURITIES TRADING & SALES: Investors Firmly Believe in Higher Rates After reaching new recent high yields in June in anticipation of the Federal Reserve raising rates, bonds began a descent in yield, post the actual announcement of the rise. This downward trend continued into July, reaching its floor in mid-month. It is a common phenomenon in the market to “sell off” in anticipation of news, only to “trade up” on the fact. In addition, with all participants believing the Fed was about to raise rates, speculative shorts had already been set for some time, pushing yields higher. With bond prices not going lower after the announcement, those holding short positions bought bonds to lock in their profits, thus creating a bond rally. With the expectation for rates to rise and important announcements to come soon, investors may wish to keep their funds in relatively short maturities. Should investors find themselves with high excess cash balances not needed for some time, investors may find an attractive avenue with Auction Rate Notes. This security has become very popular especially among corporations due to their high short-term return, float feature, availability of high credit rated issuers and put feature on coupon re-set dates. In this rate rising expectation environment, this product allows the investor to follow rates as they rise, without placing their investment in a very short-term maturing security offered at a lower return. Depending on the structure of the Note, these securities are yielding today, anywhere between .80% (tax free) and 1.75%. Interestingly enough, after the Fed rate rise and the market retracement of its June sell-off, participants received several pieces of bearish news on the economy. The labor report, Retail Sales, Housing Starts, Building Permits, the ABC Consumer Confidence Index and Leading Indicators reported in July all were weak or weaker than what economists had expected. The market, however, failed to “buy in” to the notion that the economy would be unable to sustain its recent momentum and that yields on bonds should go even lower than the post-Fed rate rise announcement rebound. In other words, bonds held their yields and did not fall more. These reports were followed by Greenspan’s remarks before Congress suggesting that the bearish news were just a “pause” in the economy and that not only would the economy sustain its momentum, but that the Fed was prepared to raise rates further. This lack of bond price follow through, coupled with Greenspan’s comments provided bond speculators the comfort to “re-set” their speculative short positions again which commenced bond yields to slowly rise again. Adding momentum to this retreat in bond prices since Greenspan’s comments have been favorable reports on Jobless Claims, Existing Home Sales and Consumer Confidence. In sum, using the 2-year maturing U.S. Treasury Note as a benchmark, its yield reached a low in July of approximately 2.50%; down from its flirtation with 3% just prior to the Fed rate rise announcement. Now, the 2-year Note has “retraced” half of it recent move and has settled in at 2.80% (see chart on right). 2 yr T-note yield: since 1/1/04 The next watershed events that participants should be focusing on will be the August labor report and FOMC meeting. A Jeff Katz 3 7/28/04 INTEREST RATE OUTLOOK Tomoko Iwakawa Over the 6/30 Federal Open Market Committee, Fed decided to raise rates by 25bp, maintained a ‘neutral’ stance on both growth and inflation in its accompanying Statement while confirming ‘measured tightening’, despite a rate hike for the first time in 4 years. The market is expecting another 25bp rate hike over the August 10 FOMC, which would put the Fed Funds target at 1.50%. Focus remains yet again on the Statement and its bias. Most recently, over the Humphrey Hawkins semi-annual testimony, Fed Chairman Greenspan had an unambiguously upbeat assessment on the US economy, such that it made the market react in thinking about any possibility of an even faster pace of tightening than ‘measured’. He said that, “if inflation pressure is stronger than expected, a more aggressive tightening would ensue”, while ”the considerable monetary accommodation put in place since 2001 is proving increasingly unnecessary”. He also mentioned that, “the recent slowdown in consumer spending should prove short-lived” and “the economy should grow strongly”. Other Fed officials have reiterated that view implying that there is still considerable distance for rates to rise before reaching ‘neutral’, which is expected to be another 200 – 350bp higher than today’s levels. This optimistic growth and low inflation outlook Is based on “strong household balance sheet” (despite low consumer savings and high debt), i.e. a result from higher net worth derived from higher asset prices such as real estate and stocks. The Treasury market sold, while equities strengthened, and so did the US$. The risk, however, is if asset prices turn around, household balance sheet will also be vulnerable. Other impediments to recovery may be the record high crude oil prices ($43.05/barrel) and possible geopolitical risks, weaker-than-expected labor market report (due on Aug 6), etc. So it is no wonder that the Fed is trying to manage market psychology in the midst of a challenging tightening cycle, which may leave some reservations when reading the Fed….. DJIA (1/1/2003~ present) 10 Year US T-note (1/1/2003 ~ present) Crude Oil (1/1/2003 ~ present) Gold Prices (1/1/2001 ~ present) 4 FOREIGN EXCHANGE OUTLOOK By David Rhee UBOC FX ADVISORY SERVICES EUR/USD CHART Foreign Exchange Market Focus The USD got a much needed shot in the arm from Fed Chairman Greenspan who’s rosy assessment of the US economy helped save the dollar’s suffering from a muddled economic picture at home. A widely anticipated and already priced-in 25 bps rate hike to begin the month had little effect on the dollar. Additionally, prospects for an aggressive rate tightening cycle appeared to fade with mixed the economic reports which led many to scale back the timetable for Fed rate hikes. In response, the dollar fell to 4 ms. lows against the euro above $1.24 until Greenspan’s comments helped lift the dollar. In testimony before Congress, Greenspan predicted growth would continue to expand and affirmed that gradual rate hikes were still on track. Review (USD/JPY) July Review (EUR/USD) USD/JPY 107.53-110.31 The yen settled into narrow ranges despite continuing signs of growth in Japan. The Japanese government doubled its GDP forecast to 3.5% for the current fiscal year—the highest in 3 years. The Tankan survey highlighting business confidence came in the highest in 13 years. Favorable business is underpinned by a firm commitment to continue its ultra loose, zero interest rate policy. The yen also overcame political obstacles when the LDP managed to hold its ruling coalition together despite losing seats in Parliamentary elections. Review (Other Currencies) July AUD/USD 0.6963-0.7345 USD/CAD 1.3055-1.3343 The fortunes of the one time high yield plays, CAD and AUD, have risen and fallen on interest rate prospects in the US; soaring when rate hikes appeared to wane and subsequently falling when Greenspan provided an upbeat outlook on the US economy. The CAD, a commodity currency, also benefited from high oil prices. Both the CAD and AUD are expected to continue to raise rates in response to strong domestic conditions in the coming months. EUR/USD GBP/USD July 1.2084-1.2460 1.8113-1.8765 Actual Previous -The euro rose to 4-ms. highs against the dollar despite lackluster economic conditions. The European Union revised down its Q3 growth forecast to 0.3%-0.7% q/q. Despite the slack economic conditions, the ECB has affirmed a neutral monetary policy stance despite calls for the ECB to cut rates. -The GBP rose to 5-ms. highs on strong domestic conditions but subsequently gave up its gains on signs that rate hikes are taking their bite. Notably, the four interest rate hikes since November are cooling the once red-hot housing sector. Most recently, the BOE held rates unchanged on cooling home prices. Outlook August In testimony before Congress, Greenspan predicted that growth would accelerate in the second half of this year as the economy gains momentum and continue into next year. His comments caught many market participants, who had pared back rate hikes estimates based upon mixed economic data in the US, by surprise. The dollar’s recent comeback is based upon the sentiment that the Fed will continue to raise rates based upon this steady, gradualist approach. Market participants are anticipating the Fed’s next meeting on Aug 10. - 5- Jobless rate Non-farm payroll (000) Trade balance ($ bln) PPI CPI Retail Sales Industrial Production Capacity Utilization 5.6% +248 -46 +0.8% +0.6% -0.5% +1.1% 77.8% 5.6% +346 -42 +0.7% +0.2% +0.2% +0.8% 77.1% GDP +3.9% +4.1% This report is published by the UBOC Global Markets Group to provide general information to its customers and prospects. This report does not attempt to address the specific needs or objectives of any recipient. And it is not an offer to buy or sell any security or other investment product. Investment products mentioned in this report (i) may involve considerable risk, (ii) are not deposits, or obligations of, or guaranteed by UBOC or its affiliates, and (iii) are not insured by the FDIC or any government agency. Recipients should consult appropriate advisers and use independent judgment before taking any action. Derivatives and foreign exchange products (except FX spot transactions) are available only for eligible swap participants as defined in 17 CFR Part 35. This report has been prepared from sources believed to be reliable but it is not guaranteed to be accurate. Any opinions expressed are not those of UBOC or its affiliates. All prices, rates and other information are subject to change without notice. UBOC and other persons may make use of or act on the information contained in this report prior to its distribution. UBOC may act as a principal or agent with respect to any security or other investment product mentioned in this report.